Question

Explain the Modigliani & Miller (M&M) capital structure irrelevance principle

Answer 1

Modigliani & Miller (M&M) is the most prominent approach in the field of corporate finance. Most of the investors use this approach to make decisions. But this approach tells us that capital structure does not have any effect on the value of the firm.

Most of the important irrelevant principle of the M&M approach is that it has assumed that markets are efficient. But in practical life, markets are not efficient because all information is not available in the market and the stock prices are not fairly priced.

Next important irrelevant principle which has been taken into account that it has assumed that bankruptcy does not exist.

So, M&M made M&M II including taxes and bankruptcy.

a. M&M in perfectly efficient markets:

Proposition 1: It works in an environment where the markets are efficient, and the company does not pay taxes. It tells that bankruptcy exists but there are no bankruptcy costs. So, it is explained as:

Value of levered firm = value of unlevered firm.

Proposition 2: It tells us that the company's cost of equity is directly proportional to the leverage level of the company.

r_E = r_A+D/E(r_A-r_D)

The above propositions are in the world of efficient markets, but in the real market, it is not the same. So, below explaining the M&M in the real world.

b. M7M in the real world:

Proposition 1: It includes the assumptions that the company pays taxes, bankruptcy costs are there, transaction costs are there, and markets are inefficient.

V_L = V_U+T_c*D

Proposition 2: It tells that company's cost of equity is directly proportional to the leverage level of the company but the tax will affect the relationship by making it less sensitive to the leverage of the company.

r_E = r_A+D/E*(1-t_c)*(r_A-r_D)